Rational Inflation Expectations Cannot Become Unmoored by the Actions of A Rational and Transparent Central Bank

This is a point I have been meaning to make for a while and Mark Thoma’s post this morning spurs me on. He writes

My view is that the costs of doing too much — the inflation cost — is much lower than the costs of doing too little, i.e. the costs of higher than necessary unemployment (though see David Altig). I’m aware that we differ on this point, those in favor of relatively immediate interest rate increases see the costs of inflation as very high and it’s this point that I hope will generate further discussion. In reality, how high are the costs of a temporary bout of inflation — I have faith that the Fed won’t allow an increase in inflation to become a permanent problem — and are they so high that they justify erring on the side of doing too little rather than too much? I don’t think they are, but am willing to listen to other views.

My understanding is that the principle fear regarding inflation is that if a sustained period of high inflation were allowed expectations would become unmoored and the Fed would lose it hard won credibility.

The problem with this view is that it flies in the face of the notion that inflation expectations are rational.

A rational agent incorporates knowledge not only of Fed behavior but of the informational and operational constraints facing the Fed. If it is in fact the case that the Fed is only risking higher inflation because it is

Uncertain about potential output

Concerned about hysteresis

Has difficulty adjusting policy at the zero lower bound

Is operating in the wake of a major international financial crisis

Then a rational agent should not conclude that long run inflation targets have meaningfully changed.

And, we must remember that rational agents are not “cynical agents.”

An agent who was irrationally cynical about the Fed’s attempt to tame inflation from the 1980s onward would have lost enormous amounts of money shorting the bond market.

Agents today face a similar gamble and it simply would not be smart to assume that a Fed that was aggressive now is giving up on its long run inflation targets.

Thus there is little reason to think that if the Fed is not in fact giving up on inflation targets that the market will believe that it is.

I think the following is true more generally, though I understand it would require a proof:

The Central Bank cannot advantage itself by attempting to send false signals to rational agents who possess the same information.

For example, making a bigger deal about inflation than what would accurately reflect the Fed’s loss function cannot serve to lower long term losses. The market will not be “fooled” by such signals into up-weighting the inflation component of the loss function in future periods, but the Fed will suffer losses in the present period.